Papering Over the Problem

Killing the dollar to save Bear Stearns

As the news broke on March 14 that the Federal Reserve would backstop the rescue of Bear Stearns by JPMorgan Chase, it’s unlikely that many of the drivers paying record-high prices at the gas stations off the West Side Highway thought to glance toward midtown, where two sleek towers housed the beneficiaries of the Fed’s largesse. But those unhappy drivers, along with every other taxpayer and consumer in the U.S., had just become partners in a deal that offers considerably greater risk than reward.

Headlines notwithstanding, this was not a “bailout” in the most widely understood sense of the word. Bear Stearns lasted barely a full trading day between the Fed’s action and the announcement of the acquisition by JPMorgan at $2 (later raised to $10) a share. Essentially it was a government intervention. To keep Bear Stearns temporarily afloat, the Federal Reserve extended credit through JPMorgan and agreed to bear the risk of loss on Bear’s collateral to the tune of $29 billion. The move stirred memories of Long Term Capital, the 1998 hedge-fund bailout that the Fed organized but did not fund, or the Resolution Trust Corporation, the government’s massive publicly financed response to the Savings and Loan crisis. On the continuum of expediency, the Bear Stearns episode falls somewhere between the two.

There were some understandable reasons for the Fed to go through JPMorgan instead of lending to Bear directly. As a practical matter, Morgan is a commercial bank, so it has access to the Fed’s discount window. Also, because of the established relationship between the two firms, Morgan could quickly evaluate Bear’s collateral for the loan. But there was another reason. The Fed realized that a direct, overt bailout of a hugely profitable Wall Street firm wasn’t feasible politically, particularly in an election year and during a recession. A latter-day RTC wouldn’t fly right now. But that doesn’t mean the situation lacks serious consequences. By dipping into the public till to help a medium-sized Wall Street firm that’s not part of the commercial banking system, the Fed implicitly pledged at least partial assistance to a whole raft of firms higher up the food chain. Of course, the unstated but understood guarantee of the government-sponsored enterprises like Fannie Mae, Freddie Mac, and the 12 Federal Home Loan Banks has always existed. But now, because the government deemed Bear Stearns worthy of a backstop worth tens of billions, taxpayers stand behind firms like Goldman Sachs, Merrill Lynch, Lehman Brothers, and Morgan Stanley as well.

That is the deal the Federal Reserve has made on behalf of the public. It’s the latest chapter in the socialization of risk and its corollary, moral hazard. Anyone who works long enough on Wall Street knows, at least subconsciously, that this is the way things work: if the going gets tough, a small coterie of unelected and mostly unaccountable officials in Washington will probably decide that your employer is too important to fail. In an effort to keep that from happening, wages, savings, fixed-income streams, and Social Security checks will be inflated away to “ensure the stability of the financial system.” Creative destruction is the mantra until things threaten to get creative in the Hamptons.

Just because the Fed understood the implicit obstacles to funding a classic, sustaining bailout of Bear Stearns doesn’t mean the temptation wasn’t there. The media almost always misses an important reality: monetary policy can effect a de facto bailout, particularly for Wall Street, almost as easily as a direct handout. In the weeks leading up to the Bear Stearns debacle, the Fed wasn’t bashful at the levers of policy. One such lever is temporary open-market operations, which the Fed uses on a daily basis to target short-term interest rates. When the Fed adds reserves to the banking system, the salutary effects of the associated liquidity spill over into other instruments, including stocks and commodities. In early February, the value of this temporary liquidity pool was $15 billion. As stress increased in the financial markets, the Fed boosted that to a high of $77 billion on March 12— just as trading-desk rumors about a possible bank failure peaked and two days before the intervention to support Bear Stearns.

The Fed was busy in other ways. That same week, on March 11, it announced formation of the Term Securities Lending Facility, to accept lower-quality collateral from primary dealers, of which Bear Stearns was one. This was just one new program whereby the Fed takes bad decisions off the books of Wall Street firms by accepting riskier paper for longer periods of time.

So Washington went all out trying to buttress Wall Street and particularly Bear Stearns. But there were consequences. On Feb. 6, with the Fed’s liquidity pool at that restrained level of $15 billion, oil traded at $87 a barrel. On March 12, responding to the Fed’s extraordinary measures, it closed over $109. Gold, in its role as monetary watchdog, was active as well. During the first week in February, it traded at $887 an ounce. A few days after the Fed’s liquidity efforts peaked, it was well over $1,000. The dollar recoiled in horror at the Fed’s onslaught. The dollar index, a measure of the dollar’s value against a basket of major currencies, plunged from $77 on Feb. 7 to $71 on the day of the Bear Stearns news, tracking the Fed’s work almost perfectly and anticipating further interest-rate cuts. The digits on those gas pumps off the West Side Highway flickered by faster and faster.

The overarching goal of those cuts, which began last year, has been to steepen the yield curve, which plots the yield on Treasury debt from maturities of three months to 30 years. Banks are more profitable with a steeper curve because they borrow short and lend long and pocket the difference. The Fed’s strategy has shown incipient signs of working. On March 18, just a few days after the Bear Stearns news, both Goldman Sachs and Lehman Brothers announced better than expected earnings. Their stocks gained by 16 and 46 percent respectively. The next day, Morgan Stanley also surprised on the upside, and its stock rose by 36 percent over the next three days. Visa’s initial public offering on March 19 was a huge success, with the stock jumping 28 percent on its first day.

But what about the public? So far, the results haven’t been as promising. Former Fed governor Lyle Gramley said, “In all past recessions, I was always quite sure that if the Fed stomped hard on the gas pedal, the economy would turn around and start to grow. But they’ve now stomped hard on the gas, and credit is not more available, it’s less available.” It’s not hard to understand the sour mood. In a March CNN/Opinion Research poll, 91 percent of respondents said they were somewhat or very concerned about the rising rate of inflation. That exceeded the proportion of people worried about jobs, the stock market, or falling home values. They aren’t delusional. In late February, the government reported that wholesale prices over the previous 12 months posted their sharpest rise since 1981.

Ludwig von Mises once wrote, “No emergency can justify a return to inflation. Inflation can provide neither the weapons a nation needs to defend its independence nor the capital goods required for any project. It does not cure unsatisfactory conditions. It merely helps the rulers whose policies brought about the catastrophe to exculpate themselves.” Yet the universe of “emergencies” has been expanding to include elections, natural downturns in the business cycle, inconvenient stock market weakness, and bad decisions by Wall Street firms—with predictable results.

Inflation’s defining characteristic is expediency. It obviates sacrifice and postpones pain. That makes it a natural complement to many political ventures, particularly unpopular wars. As early as 1965, Lyndon Johnson’s economic advisers worried about rising inflationary pressures. As Johnson resisted calls for new taxes, the deficit for fiscal 1967 came in at $9.8 billion. By the time Congress and the White House finally agreed on a tax increase in 1968, after years of escalation in Vietnam, the deficit was $25.2 billion and inflation was rampant.

Of course, it would get far worse over the next decade. Even as the seeds of inflation planted in the mid-1960s grew, Richard Nixon put pressure on Fed Chairman Arthur Burns to goose the economy for the 1972 election. That dynamic continued and worsened during the 1970s. By the early 1980s, Ronald Reagan was dealing with the consequences of decisions made by Johnson and Nixon over a decade earlier. Part of Reagan’s legacy is the latitude he gave Paul Volcker, as risky and painful as that was, to deal with those problems. Unless one believes the next president will want to take the hit for Bush’s decisions, or that someone with Reagan’s mandate and courage is about to appear, whoever is in the White House a decade from now will probably confront the economic fallout from current policies. But by that time will anyone remember how it all started? How many cursed LBJ or Nixon in 1979? The White House not only knows the answer, it’s counting on the nation’s forgetfulness.

Federal Reserve officials, safe in the arcana of their craft, might not have to depend on the public’s short memory. The opaque nature of monetary policy could do the trick. For this article, I asked customers at a gas station in New York City one question: “What’s the main reason for the high price of gas?” Five blamed either Bush or Cheney. Four blamed oil companies. Three said they did not know. Three claimed price gouging by gas stations. Two said, “Everything is going up.” Two cited “inflation,” with one mentioning the dollar. Two pointed to the campaign in Iraq. One said, “We’re running out of oil.” One blamed “big cars.” One blamed “the Arabs.” One apparently upscale customer driving a late-model car blamed “too much money being printed right now.” When pressed further, he named Alan Greenspan.

For Ben Bernanke and the current Fed, so far it looks like mission accomplished.
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Wilson Burman is the pen name for the New York City investment professional who writes The Cunning Realist blog.